Monthly Archives: June 2011

Brazil’s Capital Controls: How Successful?

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Policymakers shunned capital controls in recent decades, but the global financial crisis has brought them back into fashion in a number of emerging markets. Brazil is a case in point and its decision to impose controls looks like a good decision.

Figure 1: Summary Table of Capital Control Measures in Brazil  

Critics charge that capital controls sully the business environment and run the risk of putting a damper on all foreign investment, including the good kind that enhance a country’s long-term growth potential. According to Kati Suominen of the German Marshall Fund, “[C]apital controls on “hot” portfolio flows have a chilling effect on the more stable foreign direct investment that emerging markets covet for generating well-paying jobs and accessing new technologies.” So far, however, this has not occurred in Brazil.

Despite the controls, the overall amount of financial inflows into the country remains strong and reached US$61.8bn in first five months of 2011, almost double the US$33.7bn for the whole of 2010. Meanwhile, the composition of inflows has improved. Foreign direct investment (FDI) has picked up, while more volatile portfolio investment – aka ‘hot money’ – has waned. In particular, foreign capital flows into equities have slowed dramatically since October 2010, even more than flows into debt securities, which are taxed at a higher rate.

Figure 2: FDI has dominated capital inflows so far in 2011

Source: Banco Central do Brasil

Figure 3: FDI inflows held strong throughout the 2008-09 global financial crisis, while foreign portfolio investment fled

Source: Banco Central do Brasil

Brazil is now much less vulnerable to a sudden reversal of foreign capital (such reversals have the potential to trigger financial crises) given the composition of inflows. FDI has made up a majority of inflows since November 2010, as seen in Figures 2 and 3 above. FDI is less prone to a sudden reversal, as highlighted by the global financial crisis, and currently fully covers the financing of the current account deficit as seen in Figure 4 below.

Figure 4: FDI is sufficient to cover financing of the current account deficit

Source: Banco Central do Brasil

Brazil stands in contrast to Turkey, where the quality of capital inflows has deteriorated since the global financial crisis. For the year through April 2011, FDI flows covered less than one-fifth of Turkey’s current account deficit, making the economy more vulnerable to a sudden outflow of capital. Notably, Turkey is one of the big emerging markets that has not implemented controls on capital inflows.

Counter-arguments

There are some important counter-arguments to note when evaluating the success of Brazil’s capital controls. Some observers, including Nicolas Eyzaguirre who is the IMF director for the Western Hemisphere, have expressed concern that the shift in the composition of capital flows is due to the fact that financial flows are being disguised as FDI.

This is a legitimate concern and is likely happening to a certain degree. Nevertheless, the taxes Brazil has imposed on foreign investment should make it more challenging and costly for speculators to take this route, which should help deter hot money inflows. Capital controls aren’t a perfect barrier against short-term inflows in search of high yields, but they do put sand in the gears of speculators, which can make them useful.

The other main counter-argument is that capital controls have failed to stem upward pressure on the currency. Authorities, such as Brazil’s finance minister Guide Mantega, cited currency strength as a key reason for implementing controls. However, as seen in Figure 5 below, Brazil’s currency continues to appreciate. The real effective exchange rate – which measures the exchange rate of the real, on an inflation-adjusted basis, relative to a trade-weighted average of Brazil’s trading partners’ currencies – has appreciated 6% for the year to May. This has presented policy challenges for Brazilian authorities, who are concerned about the ability of their manufacturing exports to compete globally. (See related post: Brazil: Dutch Disease Concerns). One small bright spot is that the currency eased slightly in May on a m/m basis.

Figure 5: Brazil’s currency continues to strengthen

Source: BIS

Given Brazil’s ongoing currency strength, one could argue that the controls have proven ineffective. However, we can’t perform a controlled experiment to see what would have happened without capital controls. Arguably, the currency would have strengthened even more if they weren’t implemented.

Results of Brazil’s experiment with capital controls in line with research

Brazil’s experience with capital controls thus far falls in line with research by economists Carmen Reinhart, Kenneth Rogoff and Nicolas Magud that shows controls on inflows can accomplish the following:

• Alter the composition of inflows

• Allow for more maneuver room on monetary policy

• Reduce real exchange rate pressures (although they note the evidence on this is controversial)

They also find that controls do not tend to reduce the volume of net inflows.

Related links:

Policy Challenges in Face of Commodity Price Volatility Pablo Fonseca; April 14, 2011

Regaining Control? Capital Controls and the Global Financial Crisis Kevin Gallagher; February 2011

Capital controls: A meta-analysis approach Nicolas Magud, Carmen Reinhart and Kenneth Rogoff; March 24, 2011

Green light on capital controls raises red flags Kati Sumoninen; April 14, 2011

Emerging Markets: Fiscal Health Check

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Public debt levels in emerging markets look very attractive relative to those in advanced economies,  which has contributed to their upbeat growth outlook. See the graph below. But now is not the time for complacency.  As the IMF notes in its recent Fiscal Monitor update released on June 17th, many emerging market governments are enjoying booming revenue growth. The key is to use these good times to save for the bad.

Source: IMF Fiscal Monitor Update

Despite sprightly economic growth, all of the major emerging markets are set to continue running budget deficits, according to IMF projections and as seen in the graph below.  India, in particular, stands out for its relatively high debt stock and high projected budget deficits.

Source: IMF Fiscal Monitor Update

While it made sense for governments to use fiscal stimulus and run budget deficits to support growth when their economies slowed or contracted during the 2008-09 global financial crisis, it doesn’t make sense now. So why should emerging market governments exercise fiscal restraint?

1)   Strong revenue growth may be temporary

For the major agricultural and oil exporters, in particular, there are concerns that revenues will dry up if the current situation of high commodity prices and strong capital inflows proves short-lived.

2)   To reduce overheating risks

Many emerging markets have staged strong growth recoveries. They are operating at or close to full capacity and inflation is accelerating. Policy tightening is needed, and the IMF has explicitly warned that India, as well as Brazil, Mexico and Turkey are at risk of overheating.

Fiscal restraint would take some of the tightening burden off central banks, lessening the need for sharp interest rate hikes, which could encourage stronger capital inflows.

Bottom line: While fiscal tightening seems like an obvious  policychoice, it’s hard to implement in practice. If you’re a politician and your economy is growing, it can be hard to be the party spoiler and say no to spending.

Sidenote: The IMF chose Sao Paulo, Brazil as the location to hold the press conference to release the latest Fiscal Monitor and Global Financial Stability updates. The choice may attest to the rising importance of the big emerging markets and the IMF’s desire to pander to them, but it could also have just been a ploy for the IMF to limit questions on Greece, which seemed to dominate the Q&A portion of the event in any case. See the video here.

Can Emerging Markets Replace the US as World’s Consumer of Last Resort?

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US consumers have served as the global growth engine, but this situation is unsustainable. Falling home values, the sluggish labour market, and stagnant income levels mean US consumers remain under the gun. Can emerging markets pick up the slack?

The short answer is that emerging markets have picked up some of the slack.  As seen in the graph below, the biggest emerging markets – Brazil, Russia, India, China (the so-called ‘BRICs’) – have seen their share of global consumption rise over the past decade, from just over 13% to almost 19%. Notably, it took the BRICs nine years to grow their share of global consumption by six percentage points, which highlights the fact that this is a gradual process. Even amid the depths of the global financial crisis, when US GDP contracted by 2.6% in 2009  while China and India grew by over 8% or more, the BRICs’ share of global consumption was little changed.

Source: World Bank

Emerging markets can replace the ailing US consumer in the medium-to-long term, but not in the short-term. Most emerging markets are still heavily dependent on export-led growth. Trade between these countries is increasing, but advanced economies remain their main export destinations, at least for now.

As a result, emerging markets remain vulnerable to deteriorating conditions in the developed world. Emerging markets have staged a strong recovery since the depths of the global financial crisis and should continue to ‘decouple’, but to say that the ‘decoupling’ process is already over is premature.

Brazil: Dutch Disease Concerns

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Brazil is reaping the benefits of the boom in commodities prices. The economy expanded by 7.5% – one of the fastest paces in the world – in 2010 and the middle class is growing. Another year of solid growth is expected in 2011. Nevertheless, the country’s natural resource bounty is having unsavoury side effects and fears of deindustrialisation, in the form of Dutch disease, are rising.

Many manufacturers are struggling to export given the strength of the Brazilian real. Strong capital flows into Brazil, attracted by its economic performance and resource bounty, are pushing up the value of the currency. The head of Brazilian operations for Siemens recently told the FT that “the strong real was crushing the group’s export business in the country.”

By definition, Dutch disease strikes when commodity exports drive up the value of the currency, making other parts of the economy (such as the manufacturing sector) less competitive, which in turn leads to the decline of these other sectors and results in even greater dependence on commodities. As seen in the graphs below, there are signs of the onset of Dutch Disease.

Figure 1: Brazil’s currency has steadily appreciated since late 2008

Source: Oanda

Figure 2: Manufacturing goods make up a shrinking share of total exports

Source: IBGE

Much ado about nothing?

It’s clear that manufacturing exports are on a steady decline, but how worried should we be? Ultimately, the answer boils down to whether you see the current commodities price boom – and the related currency strengthening – as a temporary or longer-term phenomenon.

If the strong rise in commodities prices is viewed as a temporary phenomenon, then the concern is greater. If and when prices fall, the economy would likely suffer due to a fall in commodity exports and a dropoff in capital flows. As economists Albert Fishlow and Edmar Bacha note in a 2010 paper, “Capital outflows may occur, accelerating the need for devaluation in the midst of a balance of payments crisis.”

However, if the currency strength is driven by a permanent change, then it implies a ‘long-run equilibrium movement’, according to Nicolas Magud and Sebastian Sosa in a Vox post, and ‘Dutch disease should not be a concern.”

But there is a caveat….as Magud and Sosa note , it is difficult to tell whether a commodity price shock is temporary or longer-term. Misdiagnosis could lead to the wrong policy prescription. If the commodities price shock is temporary and authorities do not address the deindustrialisation underway, then they run the risk of leaving themselves with a weakened manufacturing sector that may prove difficult to revive.

The best defence is a good offence

The best policy prescription in this case is to minimise the potential hangover from the boom going bust. That involves saving during the good times in order to have a cushion for the bad times, but of course, this is easier said than done. John Lipsky, managing director of the IMF, addressed this topic in a speech on Latin America earlier this year.

From an economic perspective, fiscal policy seems like the preferable weapon of choice in Brazil’s case as it would cool the economy and would likely relieve upward pressure on the currency. While it made sense for the government to run a budget deficit during the 2008-09 global financial crisis to cushion the economy’s downturn, it doesn’t make sense now. Even so, Brazil ran a budget deficit of 2.6% of GDP in 2010 (not surprising since it was an election year) and is on course to run another deficit in 2011.

Ultimately, fiscal tightening tends to be unpopular politically. It’s challenging to disrupt the boom times with spending cuts and/or tax hikes. Brazil’s new president, Dilma Rousseff, has pledged to tighten fiscal policy, but whether she succeeds remains to be seen.

Related links:

Recent Commodity Price Boom and Latin American Growth: More than New Bottles for an Old Wine? Albert Fishlow and Edmar Bacha; May 29, 2010

When and why worry about real exchange-rate appreciation? The missing link between Dutch disease and growth Nicolas Magud and Sebastián Sosa; Vox; March 15, 2011

Latin America in an Uneven Global Recovery: Managing Abundance Speech by John Lipsky on January 24, 2011

Brazil: Economic Indicators and Forecasts Allianz

Brazil’s fiscal policy: How tough will Dilma be? Economist; February 17, 2011

Hungary and Turkey: Political Parallels?

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Hungary and Turkey both have popularly-elected leaders with authoritarian bents and strong majority governments. They show that threats to democracy are not necessarily overt, like a military coup, and can instead be subtle, involving a gradual erosion of checks and balances. These governments have infringed on media freedom and attempted to concentrate power. Nevertheless, the results from the June 12 election in Turkey are heartening and suggest the ruling party there will not enjoy unchecked power.

The ruling AK Party won Turkey’s June 12 elections, but not by a complete landslide, as seen in the graph below. The AKP does not have enough seats to ram through a new constitution on its own and will need to compromise with the opposition. In contrast, Hungary’s Fidesz government won an unprecedented two-thirds majority in April 2010 elections and has since pushed through a controversial new constitution, which has contributed to political polarisation in the country and cemented the party’s grip on power.

Distribution of Parliamentary Seats

Attacks on Press Freedom

The media, known as the ‘fourth pillar of democracy,’ can serve as an important government watchdog. However, the Fidesz- and AKP-led governments in Hungary and Turkey, respectively, have moved to limit press freedom.

In Hungary, the Fidesz-controlled parliament passed a controversial media law in December 2010 that allowed the government to impose large fines on publications considered unbalanced. Other EU member states heavily criticised the law, with Germany calling it a ‘danger to democracy.’ The government partially amended the law in early 2011, but did not revoke it. Until recently, Hungary had scored comparatively well on press freedom.

Turkey is touted as a model of democracy for Arab states to follow, but consistent infringements on press freedom suggest that Turkey’s democracy is not as healthy as it could be. A Times magazine article, from March 2011, notes the arbitrary arrests of journalists who have criticised the government and its clampdown on access to thousands of websites. About 58 of the country’s journalists have been imprisoned, according to the Turkish Journalists Association.

Populist Tendencies

Hungary’s Fidesz government has sought to pin the blame for the country’s economic problems on others. So far, the government has avoided implementing the tough structural reforms needed for longer-term fiscal sustainability in an effort to avoid alienating its domestic support base. The government had a high-profile falling out with the IMF in July 2010 as it sought to avoid implementing unpopular austerity measures. Then, later in 2010, the government imposed sector-specific taxes affecting mainly foreign-owned businesses. The government has recently announced a series of structural reforms, but there is a big question mark over whether they will actually be implemented. (See my earlier post – Fitch Raises Hungary’s Ratings Outlook: Odd Timing)

Turkey’s fiscal situation is not as problematic as Hungary’s, but it too has avoided any enforced fiscal belt-tightening. The AKP government flirted with an IMF deal during the global financial crisis, eventually deciding it didn’t need one, which in retrospect seems like a good decision. To shore up market confidence, the government then proposed a fiscal rule, only to eventually drop the idea as economic growth returned. The government has shown itself to be adept at retaining market sentiment. (See Turkey’s aborted fiscal rule by Turkish columnist Asim Erdilek.) And like Fidesz, IMF-bashing remains popular with the AKP government (See The Kapali Carsi by Emre Deliveli), even though neither Hungary, nor Turkey, currently have an active IMF programme.

One-Party Majoritarian Rule with Differences

Turkey’s AKP did not achieve a large enough majority in June 12 elections to unilaterally impose a new constitution, which is a good thing based on Hungary’s experience. In April 2011, Fidesz pushed through a controversial new charter, which contains provisions that amount to a power grab. For example, the constitution enshrines changes to the judiciary that undermine its independence.

• Hungary’s Constitutional Court will be expanded from 11 to 15 members, allowing the current, Fidesz-controlled parliament to name new members.

• The Constitutional Court will be barred from ruling on fiscal matters until public debt falls below 50% of GDP. As public debt exceeded 80% of GDP at end-2010, this implies that the court will not be able to rule on fiscal matters for the foreseeable future.

• Hungary’s constitution leaves many areas (electoral rules, party financing, the municipal system, the tax and pension regime) to be governed by supplementary laws, which future governments will find difficult to change. These laws require a two-thirds majority, and Fidesz plans to pass legislation related to these areas before end-2011. Future governments will find it challenging to piece together such a super-majority.

Why Should Investors Care?

Majority governments are often hailed for bringing political stability, which is a positive for the investment environment. But as the case of Hungary has shown, a super-majority government can also create a more uncertain business environment, leading to changes in the rules of the game without consultation or notice, as occurred with Hungary’s imposition of ‘crisis taxes’ on the foreign-dominated banking, energy, retail and telecom sectors.

Fitch Raises Hungary Ratings Outlook: Odd Timing

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Fitch raised the outlook on Hungary’s sovereign credit rating to ‘stable’ from ‘negative’ on June 6, making the ratings agency appear out of touch with events on the ground. The long-term rating on Hungary’s foreign currency debt currently sits at ‘BBB-‘, one notch above ‘junk’ status, and the outlook improvement makes a rating downgrade in the near-term less likely.

Fitch positively revised the outlook due to ‘increased confidence’ that Hungary will cut the budget deficit below 3% of GDP by 2012. Where is this confidence coming from? They point to fiscal measures detailed in the latest convergence programme (submitted annually to the European Commission) and to structural reforms announced by the government in February 2011 (see chart below) to justify the revision. However, the ‘increased confidence’ is baffling since these reforms are so far mostly words that are not yet backed by action.

Parliament has not yet passed the vast majority of these promised reforms. In fact, the government has not yet submitted most of the draft legislation, making an outlook upgrade appear premature. The situation would be similar to me pledging to run a marathon and winning a participation medal just for registering.

According to the government’s timetable, most of the legislation – including that laying out a National Employment Programme, a new disability pension system and a new Public Procurement Act – are slated for July. At that point, we can better discern whether the government is really committed to fiscal reform. Up until now, the government has resorted to temporary stopgap measures to contain the budget deficit, such as the de facto nationalization of the private pension system and the imposition of ‘crisis’ taxes on certain sectors, which will do nothing to help the country’s long-term fiscal sustainability and will likely hurt it.

Shockingly, investors continue to give Hungary the benefit of the doubt.

The Downside of Glass Half Full Thinking

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Time magazine delves into our so-called ‘Optimism bias’ in the latest issue. The articles suggest our accentuation of the positive developed as a survival mechanism so that we wouldn’t just give up on life and stick our heads in the sand. There are a host of benefits to looking at the glass half full, including improved health and higher earnings. But there are downsides as well.

Tali Sharot’s article in Time admits that ‘overly positive assumptions can lead to disastrous miscalculations” and we certainly witnessed that during the global financial crisis. Books have popped up asking different forms of the same question: “How could so many people have missed the warning signs of the biggest financial crisis in over half a century?

Part of the answer lies with the fact that we are hardwired to look at the world through rose-tinted glasses, which suggests the cycle of boom and busts will continue. Carment Reinhart and Kenneth Rogoff detail the repeated occurrence of financial crises over the past eight centuries in their seminal book This Time is Different. Nouriel Roubini’s Crisis Economics pursues a similar argument.

Maybe it’s my optimism bias kicking in, but the study of early warning signals offers some hope. As the IMF notes, “[A]lthough early warning systems are hardly infallible, they can contribute to the analysis of external risks…While they look at many of the same economic and financial variables that most analysts do, their strength is that they process the information contained in the rather large number of relevant variables in a systematic way that maximizes their ability to predict currency and balance of payments crises, based on the historical experience of a large number of countries.”

The Scramble for Agricultural Land

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Investors are on the hunt for agricultural land.  Everyone from governments to corporations to hedge funds is buying up large tracts in developing countries, primarily in Africa and South America. According to estimates, 80% of the world’s reserve agricultural land is found on these two continents. While governments in Africa have largely accepted and supported such foreign investment, a backlash is beginning to take shape in Latin America, where officials increasingly view such acquisitions as land grabs.

Why the rush for agricultural land?

  • Food security
  • The run-up in agricultural commodity prices
  • Concerns over the impact of climate change on the food supply
  • An increase in the amount of land devoted to biofuels production
  • Population growth and urbanisation

Notably, the above factors are interconnected. Both structural and speculative factors are playing a role in the rising land prices seen across a broad swathe of countries. Brazil and Argentina experienced annual price rises in the double-digits in 2010, according to the Knight Frank International Farmland Index.

The graph below (from Oxfam) highlights the structural factors underscoring the land drive. The share of land devoted to agriculture has peaked, while agricultural land on a per capita basis continues its steady decline.

Source: Oxfam, FAO, UN

However, some – such as Thomas Hoenig of the Federal Reserve Bank of Kansas City – have expressed concern that a bubble may now be underway: “History has taught us that it is nearly impossible to determine how much of the farmland boom may be an unsustainable bubble driven by financial markets.”

African governments have encouraged foreign land purchases

Foreign investors bought almost 2.5 million hectares (the equivalent of 1 million football fields) in Sudan, Ethiopia, Madagascar, Ghana and Mali in 2004-09, according to a UN FAO report. Notably, this only includes deals of over 1000 hectares, meaning the actual amount of land acquired is even larger.

Major players

  • Gulf countries (Saudi Arabia, Qatar, UAE)
  • China
  • South Korea

As the UN report notes, dependence on food imports and availability of major official reserves (sovereign wealth funds from oil revenues or trade surpluses) are common characteristics of the countries involved in land deals. The acquisitions take place primarily via state-owned enterprises and privately-owned firms, but they can also take place via sovereign wealth funds and even government-to-government deals.

The UN FAO report notes that there is a trend in the African countries surveyed toward governments easing restrictions on foreign land ownership. “In Mali, Mozambique and Ghana, investment promotion agencies facilitate the acquisition of all necessary licences, permits and authorisations. Their direct role in facilitating land access focuses on helping investors in their dealings with other agencies. A more “hands-on” role is played by Tanzania’s investment promotion agency, the TIC. This is mandated, among other things, with identifying available land and providing it to investors, as well as with helping investors obtain all necessary permits…”

Backlash is beginning in South America toward foreign ‘land grabs’

There appears to be growing unease with foreign purchases of farmland in South America and governments appear less receptive than many in Africa. A recent New York Times article discusses Brazilian officials’ concerns with China’s push for land in their country and notes that in mid-2010, the attorney general reinterpreted a 1971 law, making it more difficult for foreigners to buy land.

A recent Guardian article describes how Argentinian groups are upset by a large deal with China in the province of Rio Negro (larger than the county of Cornwall). In response, the federal government is in the process of drafting legislation to restrict foreign ownership.

Foreign land restrictions: counterproductive nationalism or legitimate response?

The debate over whether foreign land buys should be encouraged or restricted is on. Many see restrictions as a form of protectionism that will hinder development. “The tightening of land purchases by foreigners is really a step backwards into a Jurassic mentality of counterproductive nationalism,” said Charles Tang, president of the Brazil-China Chamber of Commerce.

Others suggest foreign investors do not have countries’ best interests at heart from their potential environmental impact on the land (eg. heavy use of chemicals and poor management of water resources) to a failure to produce the hoped-for economic benefits (eg. jobs and increased productivity). For example, foreigners’ purchase of land does not necessarily mean that they will cultivate it right away, which limits the purported economic benefits. “The most comprehensive research to date suggests that 80% of projects reported in the media are undeveloped, and only 20% had begun actual farming,” says Oxfam.

The debate over whether restrictions should be imposed on foreign purchases of agricultural land echoes aspects of the larger debate over capital controls.  How do governments limit speculative investment without choking off ‘good’ investment (eg. those with a long-term commitment to the country who create jobs, transfer know-how and increase agricultural productivity without massive environmental degradation.) The key is carefully crafted restrictions that align investor incentives with those of the host government, but that is much easier said than done.

Local Government Woes: Next Leg of the Crisis?

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The global economy has returned to growth, but that doesn’t mean the crisis is in the rearview mirror.  A major legacy of the first stage of the crisis is the scar left on public finances. Public debt burdens in both emerging markets and advanced economies have soared in recent years, and they have already reached a boiling point in the euro zone periphery. Mark Horton of the IMF explores the reasons behind the fast build-up in public debt in the paper Fiscal Policy Issues after the Crisis.

Governments worldwide are now in belt-tightening mode. However, financial troubles at the local government level could undermine such efforts. More importantly, defaults by local governments could slow economic growth and/or threaten financial stability. Adding to the uncertainty, local government finances tend to be harder to track than those of central governments, but they are still important for gauging a country’s overall economic health.

Case of the United States

Local governments, like the federal government, suffered a contraction in tax revenue during the recession, and they are now having trouble slashing services fast enough to keep pace with the fall in revenue. This has led to wider budget deficits and higher debt levels. A major concern is that states – those most in trouble include California, New Jersey, Ohio – will cut aid to local governments.

A dangerous snowball effect could develop, whereby rising debt levels induce higher borrowing costs, which in turn makes it more challenging for local governments to service their debt. Inadequately funded pension liabilities are adding to their woes. Rather than raising taxes and irking voters, local governments may instead opt to default. So far, no major city has done so, but there are fears that this could soon change.

How worried should we be? Meredith Whitney, a prominent analyst known for looking beyond the Wall Street consensus, has predicted that dozens of US cities will default on their muni bonds. “Next to housing this is the single most important issue in the US and certainly the biggest threat to the US economy,” she said in a recent interview. Warren Buffett, the oracle of Omaha, has joined Ms. Whitney in expressing concern. See here.

Others say such fears are overblown. See Larry Swedroe of CBS MoneyWatch. Much of his counterpoint to Meredith Whitney seems to rely on looking at past defaults and extrapolating what happened to the future (eg. in previous defaults in Orange County and NYC, bondholders were made whole so they will be this time around too), which doesn’t seem like a particularly strong argument. Bloomberg columnist Joe Mysak also goes on the offensive against Whitney. Most of the column seems to be unsubstantiated vitriol against Whitney, except for the quotes he took from a Fitch report. “Debt service is generally less than 10 percent of a state or local government’s budget, and in many cases much less…. so not paying it does not do much to solve fiscal problems (particularly as compared to the costs of such an action).”

In response to fears of default, there were large net outflows from muni bond funds in late 2010/early 2011, as seen in the graph above. According to estimates from the Investment Company Institute, inflows returned to positive territory in May. Some have taken this as a sign that all’s well with muni bonds, but that remains to be seen.

Case of Hungary

The United States is not an isolated case. Financial troubles at the local level are one of the obstacles facing Hungary as it attempts to bolster public finances. Cutbacks by the central government have added to local governments’ fiscal burden. Hungary missed meeting its general government budget deficit target of 3.8% of GDP in 2010 owing to a higher-than-expected deficit at the local government level.  By end-2010, local governments had accumulated debt amounting to over 5% of GDP.


Local government debt accounts for only a small share of Hungary’s total public debt, which topped 80% of GDP in 2010. However, it has some dangerous, potentially systemic implications. In the latest Financial Stability report, Hungary’s central bank warned that local government debt poses a risk not only to public finances, but to the health of the banking system as well.

By the end of 2010, banks’ exposure to municipalities exceeded HUF 1,000 billion (EUR3.7bn, US$5.4bn), accounting for 5% of total bank loans.  As the central bank notes, “Credit risks are further aggravated by the fact that a large portion of municipality bonds were issued with a few years grace period, during which the borrower pays interest only, without servicing the principal. Once the grace periods expire, monthly installment burdens increase which, according to our estimates, may increase the expenditures of local governments by up to HUF 25-30 billion at the system level in the coming years.”  The fact that 60% of local government debt (bonds and loans) is foreign currency-denominated (mostly Swiss francs) has added to solvency concerns.

In Hungary, there is not much data on local governments’ fiscal situations, which makes it challenging to evaluate. This is the case in many countries.

Case of China

Even before the global financial crisis, analysts worried that debt-laden local governments in China, if allowed to default, posed a risk to macroeconomic and financial stability. See this blog post from World Bank economist Louis Kuijs which details the issue: China’s local government debt—what is the problem?

A recent news report from Reuters suggests regulators are finally moving to address the problem. The central government is reportedly set to pay off some of local government loans, but banks would also take part of the hit. However, China expert Michael Pettis says that while it’s good that authorities are recognising and quantifying the problem, it doesn’t address who will ultimately foot the bill for the losses.